Measuring Currency Pressure and Contagion Risks in Countries under Monetary Unions: The Case of Euro

By Canofari, Paolo; Piersanti, Giancarlo Marini Giovanni | Atlantic Economic Journal, December 2014 | Go to article overview

Measuring Currency Pressure and Contagion Risks in Countries under Monetary Unions: The Case of Euro


Canofari, Paolo, Piersanti, Giancarlo Marini Giovanni, Atlantic Economic Journal


Introduction

The period of high turbulence in international financial markets that started in 1992 with the collapse of the exchange rate mechanism (ERM) in Europe has continued unabated over the years. The growing fears of a currency crisis in the European Monetary Union (EMU) have now revitalized interest in the choices and consequences of exchange rate regimes. An influential view known as the two comer or bipolar hypothesis states that only two extreme exchange rate regimes are crisis-proof: irrevocable fixed rates or hard pegs, such as currency unions, currency boards or full dollarization, and free floating. Intermediate forex exchange regimes, including soft pegs (such as conventional fixed pegs, crawling pegs, horizontal and crawling band) and managed floats, are inevitably exposed to speculative attacks and hence are not viable in a world of global capital markets (see, e.g., Eichengreen 1994; Summers 2000; Fischer 2001, 2008).

The devaluation of the Coummunaute financiere d'Affique (CFA) franc under a currency union in 1994, the speculative pressure on the Hong Kong Special Administrative Region's currency board in 1998, the collapse of the Argentinian currency board in 2002, and the perceived risk of a euro breakup in 2011, on the one hand, and the pressure on the Canadian dollar in 1992, the Italian lira in 1995, the South African rand in 1998 and 2001, and the global crisis of 2008, on the other hand, lead one to seriously question the two extreme ends of the bipolar spectrum. The foregoing provides the basis for a more balanced approach that shows speculative attacks and crises about as likely to occur under the comer solutions as they are under the intermediate regimes (see, e.g., Ghosh et al. 2010).

In order to measure tensions on the foreign exchange market to assess the vulnerability of countries to crisis, economic theory has developed a variety of analytical tools proposed to act as an effective early warning signal. One of the warning devices that are frequently used in the literature is the index of exchange market pressure (EMP), first formulated by Girton and Roper (1977) and further extended and improved by Weymark (1995) and Eichengreen et al. (1996). The index is a weighted average of the changes in exchange rates, international reserves, and interest rates and can be applied to measure tensions in pegged or floating exchange rate regimes. (1)

We propose to evaluate the sustainability of currency unions employing an alternative index based on cost-benefit analysis. A hard peg regime is viable when our indicator shows the capability of the member countries to remain in the hard peg regime, based on the relationship between the shadow exchange rate and the output gap. This is possible as long as the difference between the costs of staying relative to the benefits does not exceed a critical value. (2)

The Model

Our indicator builds on a model of currency crises that combines the features of both first and second generation approaches into a simple model of contagion. (3) Opting out is a result of an optimizing behavior by the policy maker and occurs when a threshold gap between the shadow exchange rate and the entry parity is reached; contagion follows from a broad set of channels transmitting monsoonal and spillover effects, and pure contagion across countries (see, e.g., Masson 1999a,b; Cavallari and Corsetti 2000; Buiter et al. 2001; Berger and Wagner 2005; Arghyrou and Tsoukalas 2011; De Grauwe 2011).

Consider a multi-country setting consisting of two peripheral economies (e.g., two European Union (EU) countries or two emerging countries), an industrial (or leader) country (e.g., the United States or Germany) or a currency union (e.g., the EMU), and the rest of the word. Let the superscript A and B be used to distinguish the two external countries, and assume, for simplicity, that all structural parameters are the same in the two countries. …

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